Spending Sprees And Tax Hikes: The Highs And Lows Of The

UNCLAS SECTION 01 OF 03 LONDON 002970

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN ETRD EINV UK
SUBJECT: Spending Sprees And Tax Hikes: The Highs And Lows Of The
UK Pre-Budget Report

LONDON 00002970 001.2 OF 003



1. (SBU) Summary: The November 24 2008 UK Pre-budget report (PBR)
announces a GBP 20 billion stimulus package and deficit financing to
respond to the recession brought on the global financial crisis.
Government debt will double to GBP 1 trillion over the next few
years before declining, and the budget will not be in balance again
until 2016. The PBR projects the stimulus will add approximately
0.5 percent to the previously forecast negative growth for 2009 of
-1.5 percent. The stimulus package includes a 2.5 percent reduction
in the Value Added Tax (VAT),advancing infrastructure projects, and
spending to help individuals and companies most affected by the
economic downturn. The package will be paid for by future tax
increases, including a 0.5 percent increase in the National
Insurance levee. In addition, it includes a new upper tax bracket
of 45 percent for the wealthy, signaling a return to income
redistribution and an end to the "New Labour" policy not to increase
the maximum tax rate. Politically, the PBR evidences Prime Minister
Brown's transformation in the eyes of the public from an indecisive
risk-averse ditherer who couldn't prevent a run on the Northern Rock
bank to a decisive innovative thinker, willing to take bold action
and lead the world's developed economies by example. Brown's
turnaround in the polls, narrowing the Tory lead to single digits,
is largely due to his emergence over the last few months as a leader
in responding to the financial crisis. End Summary.

Background: PM Brown On The International Stage
-------------- --------------


2. (U) The first UK victim of the global financial crisis was the
mortgage lender Northern Rock (NR). It sought funding from the Bank
of England in the fall of 2007 as wholesale credit markets seized
up. A run on the bank led ultimately to the government
nationalizing NR in February. The government's handling of the NR
crisis evoked widespread criticism of both Prime Minister Brown and
Chancellor Darling. Their dithering was said to have made the NR
crisis worse and was consistent with Brown's reputation for being
highly risk averse and not wanting to make tough decisions. The
dithering moniker contributed significantly to Brown's declining
poll data through the first half of 2008. As the financial crisis
worsened, Brown reversed his political fortunes by positioning
himself and his government to appear as leaders in developing a
global consensus on responding to the crisis and reforming the
structure of the world's financial system. At the G-7 meeting in
Paris, Brown argued for aggressive coordinated monetary policy
action among central banks and significant fiscal stimuli. Brown
continued these themes at the November G-20 meeting. His aggressive
handling of the UK response to the deepening global financial crisis
not only reversed his declining poll numbers but has narrowed the
Tory lead to single digits. The 2008 PBR certainly reflects Brown's
newly adopted preference for taking bold action.

Strategy: A Fiscal Stimulus Package
-------------- --------------


3. (U) To respond to global financial challenges, the PBR proposes
a large immediate fiscal stimulus package plus borrowing to offset
declining government revenue. Without referencing Brown's "golden
rule" that the government should only borrow to invest rather than
to finance expenditure, and his "sustainable investment rule" that
government borrowing should not exceed 40 percent of GDP, the PBR
abandons them completely. The objective is to keep people employed,
restore consumer confidence, and get them spending again. According
to the PBR, the economy will turn around in the second half of 2009.
Future taxes and a recovering economy will pay for the program.
Significantly, the government signaled it was abandoning a key tenet
of Tony Blair's "New Labour" and returning to Labour's traditional
philosophy of income redistribution by announcing a new higher tax
bracket on the wealthy.

The Key Elements
--------------


4. (U) The largest part of the Chancellor's GBP 20 billion fiscal
stimulus package is a value-added tax rate cut of 2.5 percent to 15
percent from December 1, 2008 to December 31, 2009. This will ease
the annual tax burden by GBP 12.4 billion. A number of public
infrastructure projects, totaling GBP 3 billion, are being brought
forward to support jobs during the slump. Increasing personal tax
allowances will ease the tax burden a further GBP 3.6 billion,
corporate tax measures will ease the burden on businesses by GBP 500
million and delaying higher vehicle excise duty rates for more
polluting cars will ease the burden by GBP 500 million.

The Impact On Growth: Government Projections
-------------- --------------


5. (U) The Chancellor told MPs that the measures adopted were
designed to limit the length and depth of the recession. HM

LONDON 00002970 002.2 OF 003


Treasury forecasts a short, shallow downturn with output recovering
quickly by mid-2009. It forecasts GDP growth of 0.8 percent in
2008, between -0.75 percent and -1.25 percent in 2009, and positive
growth of between 1.5 percent and 2 percent in 2010. These
projections represent a marked change from those in the March
Budget. In March, Darling estimated growth of about 2 percent for
this year and 2.5 percent in 2009. These forecasts were based on
the belief that the credit crunch would ease in the second half of
this year and that financial market conditions would return to
normal by 2009. Despite these substantial downgrades, Darling's
projections are still more optimistic than many independent
forecasts, particularly with regard the timing of a recovery.

Implications For Government Finance
--------------


6. (U) An economic slowdown, combined with a GBP 20 billion
stimulus package, will have a dramatic impact on the state of public
finances. The tough economic climate has significantly reduced tax
revenue, with receipts from the financial sector alone expected to
fall by 35 percent this year. This will result in higher borrowing
levels - with forecasts of GBP 78 billion this year and GBP 118
billion in 2009, or 8 percent of GDP. UK net debt, as a share of
GDP, will increase from 41 percent this year, to 48 percent in
2009/2010 and will peak at 57 percent in 2014. If these fiscal
projections are accurate, the budget will not balance until
2015/2016.

The Next Challenge: Repayment
--------------


7. (U) The record borrowing levels will be paid for via a
tightening fiscal policy from 2011 (notably, this will occur after
the next general election which must be held no later than 2010).
National insurance contributions will increase for both employers
and employees and a new 45 percent tax bracket will be introduced
for those earning more than GBP 150,000 annually. The Chancellor
also announced increased government efficiency savings of GBP 5
billion in 2010/2011.

Policy Implications
--------------


8. (U) Environmental: The Chancellor said he is determined that
the present economic uncertainty should not undermine the priority
of protecting the environment. During his statement in the House of
Commons, Darling announced that he has scrapped plans for a
per-plane tax (introduced in the 2007 PBR) to replace air passenger
duty (APD),despite cross-party support for the aircraft tax.
Instead, a four-band APD will be introduced so those flying the
furthest will pay the most. The reformed APD will be implemented
from November 1 2009, moving from two to four distance bands to
improve environmental signals. The policy u-turn was made,
according to the Chancellor, in order to ensure greater stability
and to protect competitiveness at a time of economic uncertainty,
while also reducing emissions from aviation. The PBR extends the
Renewables Obligation for an additional ten years, to 2037. (Note:
The Renewables Obligation was developed as an incentive to encourage
new renewables generation by placing a mandatory requirement for UK
electricity suppliers to source a growing percentage of electricity
from eligible renewable generation capacity. End note.) The
Chancellor reconfirmed the UK's commitment to meeting its Kyoto
targets, to legislation that sets binding commitments to cut
emissions through the Climate Change Bill, and to the EU Emissions
Trading Scheme.


9. (U) Business: The PBR included measures to improve business
access to credit and to ease cash flow problems. The Chancellor
announced that foreign dividends received by large and medium groups
on ordinary shares and most non-ordinary shares will be exempt from
UK tax. Small businesses facing difficulties will be able to spread
their payable tax over an affordable timetable. HMG has also agreed
a GBP 4 billion deal with the European Investment Bank to provide
money to banks to pass on to SMEs. HMG will offer credit through a
temporary Small Business Finance Scheme, allowing small businesses
to borrow up to a million pounds on flexible terms. The Chancellor
decided to defer the increase in the small companies rate of
corporation tax. The total package of measures for businesses,
including the money from the EIB, comes to GBP 7 billion.

Reactions: "Could Do Better"
--------------


10. (U) The Shadow Chancellor, George Osborne, said the PBR
highlight the deception in PM Brown's claim to have abolished boom
and bust. He noted that the Chancellor announced the largest amount
of borrowing ever undertaken by a British government. Osborne said

LONDON 00002970 003.2 OF 003


HMG's decision to double the national debt to GBP 1 trillion is the
bill for Labour's decade of irresponsibility, initiated by the Prime
Minister. He said the Chancellor has created a "huge unexploded tax
bombshell", timed to detonate underneath the future economic
recovery. Osborne added that this is confirmation of the "time-old
truth that in the end all Labour Chancellors run out of money and
all Labour governments bring this country to the verge of
bankruptcy." He concluded that this PBR is all about the political,
not the economic, cycle as the tax rises, planned for 2011, do not
come until after the next general election.


11. (SBU) If the Chancellor had a report card, it would be marked
"could do better" by the Director General of the British Chambers of
Commerce, David Frost. Frost said there are a few good
announcements, including the deferment of the Small Business Rate of
corporation tax and allowing businesses to spread out the payment of
their tax bill, but he was very critical of the proposal to increase
national insurance contributions. He said that while the economy
should be coming out of recession, businesses will face an
additional tax. David Kern, the BCC's Chief Economist, notes that
while the PBR goes a long way towards acknowledging the UK is facing
a serious recession, the forecasts are too optimistic. He expects
growth in 2009 to be worse than predicted and is doubtful that
positive quarterly GDP growth would start as early as mid-2009.
Professor David Miles, Morgan Stanley's Chief UK Economist, is more
optimistic about HMT's growth forecasts and said the short term
fiscal boost to the economy is substantial and will potentially
generate a boost of 0.5 percent to 1 percent of GDP in 2009/10.
However, Miles says the VAT cuts, while quick to implement, will
likely not have as big a multiplier effect as other types of fiscal
stimulus would have.

TUTTLE